How do the sample Series Seed financing documents differ from typical Series A financing documents?

March 14, 2010

After the recent announcement of the Series Seed Financing documents by Marc Andreesen, Brad Feld points out that there are now four sets of “open source” equity seed financing documents:

My general opinion is that anything that makes the financing process faster and easier or otherwise educates entrepreneurs is a good thing.  (A reminder that anything I write on this site is only my personal opinion and does not represent the views of WSGR or anyone else from WSGR.)  In addition, I think that a “peace treaty” between early-stage investors and startup companies on standard terms (at least at a term sheet level) is a step in the right direction.

I previously wrote a post titled “How do the sample Y Combinator Series AA financing documents differ from typical Series A financing documents (or what’s the difference between seed and venture financing terms)?“  Much of the commentary on the Y Combinator documents is also applicable to the Series Seed documents.  (In fact, I recyled part of that post in writing this post.  I also reviewed the TechStars documents last year and they are similar in concept to the Y Combinator documents as the chart below indicates.)

This post assumes that you have a basic understanding of Series A financing terms.  If you don’t, please educate yourself on this site, Venture Hacks and the term sheet seriesby Brad Feld/Jason Mendelson, among other places. If you really want to understand the nuances in venture capital financing documents, please review the NVCA model venture capital financing documents

What situations should the Series Seed documents be used in?

The Series Seed documents are probably fine in situations where the investor (i) wishes to purchase equity rather than convertible debt, (ii) is otherwise somewhat indifferent on terms other than percentage ownership of the company, liquidation preference and right of first offer in future financings, (iii) is investing at a fairly low valuation (i.e. a couple of million dollars), and (iv) is only investing a small amount (i.e. under $500K).

I was actually somewhat surprised that the following investors have agreed to use the Series Seed documents in certain of the their deals:  Baseline, Charles River Ventures, SV Angel (Ron Conway), First Round Capital, Harrison Metal Capital, Mike Maples, Polaris Venture Partners, SoftTech VC and True Ventures. In contrast, Fred Wilson says while he is ”hugely supportive of his intent here, I can’t and won’t get behind the Series Seed forms because they leave out some critical stuff that we simply won’t do a deal without.“ 

I think that there are certain situations where the Series Seed and other stripped down equity financing documents might be appropriate, but I know that there are lots of situations where early-stage investors probably wouldn’t agree to the Series Seed terms.

Recently, I have seen a lot of seed stage financings being structured as convertible debt with a price cap, which is an alternative to the equity financing contemplated by the Series Seed documents. Certain angel investors refuse to do convertible debt deals, but will be okay if there is a price cap. In fact, I have seen convertible debt used to raise up to $1.0 million, but it seems like the sweet spot is around $500K.  Convertible debt documents are generally much more simpler to draft and read than equity financing documents, so I typically recommend convertible debt for companies raising below around $750K.

In my experience, if a company is raising, say $1.0 million, the investors expect to receive a full set of Series A documents with rights essentially the same as venture capital investors.  Therefore, the Series Seed documents may not be acceptable in these situations.  I think that the Series Seed documents are probably most appropriate in a friends and family equity seed financing, as opposed to a round led by a professional investor.

Why is it called Series Seed?

To differentiate it from typical “Series A” preferred stock, which comes with certain expectations with regard to rights.  There is no real rule to what a particular series of preferred stock is called.

What rights does the Series Seed have?

Ted Wang explains most of the highlights of the documents.  The primary rights in these documents, ranked in order of importance in my opinion are:

  • Future rights.  If new investors get better rights in a future equity financings (such as registration rights, price-based anti-dilution, redemption rights, etc.), then the holders of the Series Seed get these better rights.
  • Board seat.  The Certificate of Incorporation gives the Series Seed a board seat, while the common get two board seats. 
  • Information rights.  The investor receives unaudited annual and quarterly financial statements.
  • Drag along.  The Series Seed documents include a fairly harmless drag-along provision, which requires the investors and the key common stockholders to vote in favor of a “deemed liquidation event” (which basically means sale of company transaction) if a majority of the holders of common stock, a majority of the holders of the Series Seed and the board approve the transaction.  Given the general theme of the documents to eliminate unnecessary provisions, it strikes me as somewhat odd that there would be a drag-along. If I represent investors in a later Series A financing, I would probably use the existence of the drag-along as an excuse to implement a more aggressive drag-along provision — which does not require the approval of the holders of common stock to trigger.
  • Legal fees.  The company is obligated to pay $10K for investors counsel.  I suspect that this seems reasonable if there is basically no due diligence due to the early stage of the companies.  (By the way, the TechStars documents and the Y Combinator documents do not have a provision to reimburse counsel for the investors, probably on the theory that the situation where the documents are used don’t require counsel to review the documents on behalf of the investors.)

What are the primary rights that are missing from the these documents that would be in a typical Series A financing?

In the Series Seed documents, there are various terms that are missing that one would typically expect in a company-friendly Series A term sheet.

  • Dividend preference.  Almost all startup companies don’t declare dividends, so deletion of a dividend preference is irrelevant to an investor.  The only practical situation that I can think of where a dividend preference is beneficial to a stockholder is where a company does a partial sale of assets and wishes to distribute the proceeds to stockholders. The liquidation preference would not apply in this situation, and any distribution to stockholders would trigger the dividend preference.
  • Registration rights.  As a practical matter, I don’t think that investors should really care about registration rights.
  • Anti-dilution protection.  Deleting anti-dilution rights saves several pages of text in the Certificate of Incorporation. Given that the Series Seed is issued at a fairly low valuation, anti-dilution protection is probably not that important, as a “down round” from a low valuation in the Series Seed is unlikely.
  • Comprehensive protective provisions.  The Series Seed documents are fairly light on protective provisions compared to a typical Series A financing.
  • Co-sale rights.  These rights are missing, which is probably okay since I have never heard of a co-sale right being used before.
  • Voting agreement.  In a typical venture financing, there is a voting agreement that governs how specific board seats will be filled.  In angel financings, I typically eliminate the voting agreement anyway and simply have a closing condition that the board consist of certain persons.
  • Comprehensive representations and warranties.  The Series Seed Stock Purchase Agreement has fairly limited reps and warranties.  As a practical matter, investors don’t sue companies for a breach of reps and warranties, so reps and warrants basically serve to flush out diligence issues.  In an early stage company, extensive reps and warranties are probably unnecessary.
  • Legal opinion.  A company counsel legal opinion is missing in these documents.  A legal opinion for a newly-incorporated early stage company probably doesn’t add much to the due diligence process and is probably unnecessary compared to the incremental cost to prepare.

Why will or why won’t people adopt the Series Seed documents?

  • Investor pressure.  The only way that the Series Seed documents will be widely used is if investors demand use of the documents.
  • Investors want additional protections. I suspect that things like lack of anti-dilution protection, a desire to have participating preferred stock and weak protective provisions will make it difficult for some investors to agree to use the documents without modification.  Once you start making substantial changes to the forms, then I think some of the value of standardization goes away.
  • Law firm resistence.  As a reference point, WSGR generally does not use the NVCA documents in a Series A financing when it represents the company unless the investor specifically demands that the NVCA documents be used.  This represents approximately 20% of all venture financings in the U.S. I’ve read the WSGR form Series A documents hundreds of times (and probably have most of the provisions memorized).  I think I’ve only come across the NVCA forms a couple of times, and both times were on deals with Boston-based company counsel, where use of the NVCA documents is more widespread.  In addition, WSGR’s Series A documents can be created using the document automation software behind the WSGR term sheet generator. Therefore, using WSGR form documents when I represent a company is much more efficient than using the NVCA documents.
  • Drafting issues in later rounds. One thing that I don’t like about stripped down documents is that adding provisions in the future is painful — especially if the documents are not written in a modular fashion.  For example, adding in the anti-dilution provisions into the Series Seed documents requires the insertion of a couple of pages of text into the Certificate of Incorporation.  It’s somewhat painful to ensure that all of the section references (including Microsoft Word auto-reference codes) and defined terms work properly.  Therefore, in my opinion, it’s actually more difficult to add the modular sections than it would be to start from a new robust template and tweak it to fit the term sheet.  I’d encourage the Series Seed project to have redlines of at least the Series Seed Ceritificate of Incorporaiton against the form of Series A Certificate of Incorporation that it was based on in order to show that the documents can easily be modified in a Series A financing to include anti-dilution and other provisions.  (It seems like the Series Seed Certificate of Incorporation is mostly based on the NVCA form of Certificate of Incorporation with various formatting and simplification-related changes.)
  • Use of different forms for later Series A financing.  As a practical matter, in a typical Series B financing, the Series A documents will generally be tweaked slightly for the Series B, and company counsel will send redlines to investor counsel to show changes from the Series A (which are typically minimal).  When a company does a Series A financing and the Series Seed documents are in place, the Series Seed Stock Purchase Agreement and Investors Rights Agreement will probably not be re-used.  As discussed above, the Certificate of Incorporation will need to be amended and restated and various provisions will need to be plugged in.  (By the way, restated means that the entire document is redone in its entirely, as opposed to just an amendment, which might refer to discrete sections like: “Article IV shall be amended such that the number of shares of Common Stock shall be 15,000,000.”)  The Series Seed Stock Purchase Agreement has no lingering obligations, so Series A investors will want a more traditional stock purchase agreement with closing conditions and closing certificates — and it is much easier to use a typical Series A Stock Purchase Agreement than modify the Series Seed Stock Purchase Agreement.  In addition, there will be so many new provisions added to the Investor Rights Agreement (such as registration rights) that starting from a more robust form is easier than adding provisions to the Series Seed Investor Rights Agreement.

What’s the difference between the Series Seed documents, the TechStars documents, the Y Combinator documents and TheFunded Plain Preferred term sheet?

The Y Combinator documents were released in August 2008.  The TechStars documents were released in February 2009. TheFunded released their “Plain Preferred” term sheet in August 2009.  The Series Seed documents were released in March 2010.  Below are some of the material differences between the Series Seed, Y Combinator and TechStars documents.  (I won’t bother outlining the differences in TheFunded term sheet, as it was more intended for a typical Series A institutional venture capital financing, as opposed to the seed stage contemplated by the other documents.)

 

Series Seed

Y Combinator

TechStars

Name of security

Series Seed

Series AA

Series AA

Principal documents

COI, SPA, IRA

COI, SPA, IRA

COI, Subscription Agt.

Dividend preference

Pro rata with common

Silent

Pro rata with common

Liquidation preference

1x non-participating

1x non-participating

1x non-participating

Redemption rights

None

None

None

Anti-dilution

None

None

Broad-based weighted average

Board composition

2 common; 1 preferred

2 common, 1 preferred

2 common, 1 preferred (if Series AA is at least 5% of fully-diluted)

Protective provisions

Typical list for company-friendly VC financing

Changes in preferred and merger/sale of assets only

Changes in preferred only

Information rights

Unaudited annual and quarterly

Unaudited annual and quarterly

Unaudited annual

Registration rights

None

None

None

Right of first offer on new financings

Yes

Yes

Yes

Right of first refusal and co-sale agreement

Assignment of company right of first refusal to investors

Silent

Silent

Drag-along

Yes for Series Seed holders and founders. Triggered upon (i) majority of common, (ii) majority of Series Sees, and (iii) board approval.

No

No

Future rights

Yes

No

Yes

Legal opinion

None

None

None

Legal fees

$10K to investor counsel

None

None

 

What would you change about the documents?

I’m still pondering and will update this post later after I speak to some early-stage investors.

How do you find federal and state government funding opportunities for clean tech and other companies?

December 22, 2009

[I know it's been a long time since I posted anything, but I was recently accused of having a dead or dying blog and felt compelled to post something.]

Wilson Sonsini Goodrich & Rosati provides a powerful online tool that provides clean technology entrepreneurs and companies with a searchable, easy-to-use source for federal and state government funding opportunities and guidance on how to apply.

The publicly available tool aggregates and frequently updates the numerous financing opportunities, such as grants, loan guarantees, tax credits, and other programs, being offered by federal and state governments. Users are able to search by industry sector, as well as by state-by-state resources. The tool also includes articles by Wilson Sonsini Goodrich & Rosati attorneys on how to take advantage of governmental funding opportunities, links to useful federal and state websites, and additional firm publications such as The Clean Tech Report and relevant WSGR Alerts and press releases.

The tool may be accessed through the Wilson Sonsini Goodrich & Rosati website at http://www.wsgr.com/cleantech.

WSGR online venture financing term sheet generator

April 22, 2009

[Below is the text of a WSGR email update.]

Always looking for ways to better serve the entrepreneurial community, Wilson Sonsini Goodrich & Rosati is pleased to announce the release of the WSGR Term Sheet Generator, a publicly available online tool that allows entrepreneurs and investors to generate an initial draft of a term sheet for a preferred stock financing. By answering a series of questions, users are guided through the principal variables contained in a venture financing term sheet. Brief explanations of the questions and typical deal terms are included. After answering as many questions as desired, users can generate, print, and save a Word version of the term sheet, which is intended to be useful in deal discussions between entrepreneurs and investors and in crafting a final, customized term sheet with the help of attorneys.

The term sheet generator is another example of the firm’s commitment to providing services to our clients more quickly and efficiently. Our attorneys use a more extensive version of the tool to generate initial drafts of documents for Series A preferred stock financings, including Certificates of Incorporation, Preferred Stock Purchase Agreements, Investor Rights Agreements, Right of First Refusal and Co-sale Agreements, Voting Agreements, corporate approvals, and closing documents. By using this tool, we believe that we are able to represent clients and complete transactions more efficiently. We also have a similar tool for generating initial drafts of more than 20 start-up company formation documents. In addition to document automation, Wilson Sonsini Goodrich & Rosati has developed other sophisticated knowledge management and related resources that enable our attorneys to better serve clients by tapping the essential expertise and experience of the entire firm.

Users with general comments regarding the WSGR Term Sheet Generator should contact partner Yoichiro (Yokum) Taku at ytaku@wsgr.com or Practice Resources Special Counsel Anthony Kikuta at akikuta@wsgr.com. To learn more about Wilson Sonsini Goodrich & Rosati’s entrepreneurial services, please click here.

[Update:  See below for various mentions of the term sheet generator.]

Altgate:  Law Firm Wilson Sonsini Now Preparing Term Sheets For Free (Furqan Nazeeri provides a review of the tool along with a sample term sheet that he created.)

Mendelson’s Musings: Wilson Sonsini Term Sheet Generator

Legal Blog Watch: Law Firm Replacing Itself With Free Term Sheet Generator

Guy Kawasaki:  Free Online Term Sheet Generator

WSJ Blogs: The Daily Startup: Putting Terms in Entrepreneurs’ Hands

ABA Journal: Wilson Sonsini Offers Free Document Assembly Tool

Adams Drafting:  The WSGR Term Sheet Generator: The Inoxerable Creep of Document Assembly

Prism Legal: New WSGR Term Sheet Generator – an Innovative Online Service

Law Shucks:  WSGR Term-Sheet Generator

Startup CFO:  Automatic Term Sheet Generator

The Startup Lawyer:  WSGR Launches Term Sheet Generator

VC Confidential: Term Sheet Tool

CenterNetworks:  Wilson Sonsini Launches Free Term Sheet Generator

Strategize:  Wilson Sonsini Term Sheet Generator

Sophisticated Finance:  Wilson Sonsini Term Sheet Generator

Kentucky Startup Blog: Term Sheet Generator

Steven Cox: Need a Venture Capital Term Sheet?  Here’s a FREE One

Legal Process Outsourcing:  Have Wilson Sonsini Read “The End of Lawyers?”

Barron’s:  For the Startup with No Money to Pay Pricey Lawyers:  Wilson Sonsini’s Do-It-Yourself Term Sheet Generator

Reuters:  Free financing tool to help startups get legal ball rolling

Reuters:  Hoopla over automated term sheet may be legit

WSJ Law Blogs:  Wilson’s Little Gift to the World

Xbusinessman:  WSGR term sheet generator (in Japanese)

The Lean Marketer: Online Term Sheet Generator for Venture Capital Funding

Why do preferred stockholders have odd economic incentives upon a sale of company when they have non-participating preferred stock or particpating preferred stock with a cap?

December 20, 2008

Even savvy investors often don’t understand the subtle nuances on economic incentives that result from non-participating preferred stock or participating preferred stock with a cap in the event of a sale of company.

Assume a simple cap table of:

10,000,000 shares of common stock

10,000,000 shares of Series A preferred stock

Also assume that the Series A preferred stock has a $1.00/share liquidation preference and is non-participating.

If the company is sold for between zero and $10M, then all of the merger consideration would go to the holders of Series A.

If the company is sold for $10M to $20M, the holders of Series A would still receive $1.00/share as a rational Series A holder would never convert his/her shares to common as the Series A holder would receive more from the Series A liquidation preference than as a holder of common.  For example, if the merger consideration is $15M, then the Series A would receive $1.00/share and the common would receive $0.50/share.  Thus, the holders of Series A are indifferent between sale prices from $10M to $20M, which may lead to odd economic incentives.  Hypothetically, a venture capital fund holder of Series A might not want a company to argue hard over merger valuation with an acquiror if there is no marginal benefit to the fund and there is a risk that the deal may fall apart.

If the company is sold for over $20M, the holders of Series A would convert to common (assuming that they are economically rational).  For example, if the merger consideration is $30M, then the common would receive $1.50/share (assuming all Series A converted).  Of course, if some holders of Series A did not act in their optimal economic interest and convert, then the merger proceeds available to the common would increase and the common would receive greater than $1.50/share.

Similarly, if the Series A is participating with a cap, there will be a range of merger consideration values where the holders of Series A will be indifferent because the cap has been met, but it still does not make economic sense for the Series A to convert.

In the same example, assume that the Series A has a $1.00/share liquidation preference and is participating with a 3X cap.

Like the non-participating preferred, if the company is sold for between zero and $10M, then all of the merger consideration would go to the holders of Series A.

For merger consideration greater than $10M but less than $50M, the Series A participates with the common on the amount over $10M.  For example, if the merger consideration is $20M, the holders of Series A would receive $1.50/share, or an aggregate of $15M (which represents the $10M liquidation preference and $5M of participation with the common), and the holders of common would receive $0.50/share, or an aggregate of $5M.

If merger consideration is $50M, the holders of Series A would receive $3.00/share, or an aggregate of $30M (which represents the $10M liquidation preference and $20M of participation with the common), and the holders of common would receive $2.00/share, or an aggregate of $20M.  At $50M, the Series A hits the 3x cap on participation by receiving $3.00/share.

If the company is sold for $50M to $60M, the holders of Series A would still receive $3.00/share as a rational Series A holder would never convert his/her shares to common as the Series A holder would receive more from the Series A liquidation preference than as a holder of common.  For example, if the merger consideration is $55M, then the Series A would receive $3.00/share and the common would receive $2.50/share.  Thus, the holders of Series A are indifferent between sale prices from $50M to $60M, which may lead to the same odd economic incentives as the non-participating preferred stock, albeit at higher transaction values.

If the company is sold for over $60M, the holders of Series A would convert to common (assuming that they are economically rational).  For example, if the merger consideration is $60M, then the common would receive $3.00/share (assuming all Series A converted).

Please see the liquidation preference spreadsheet and program some examples if you want to proof this yourself.

What is upgradeable Series A preferred stock?

September 12, 2008

Occasionally, I see a new provision in a term sheet, which keeps things interesting for me. I’ve decided to call this type of Series A preferred stock “upgradeable” (after recently realizing that there are economy class plane tickets that aren’t upgradeable despite having system-wide upgrade certificates). The term sheet provides:

The Series A Preferred shall also be convertible into any future series of Preferred Stock (the “Future Preferred”) under either of the following circumstances: (a) if such conversion is approved by the Board or (b) if such conversion is in connection with a future Preferred Stock equity financing in which the Company’s fully diluted pre-money valuation is greater than the Company’s fully diluted post-money valuation immediately following the Series A Financing contemplated by this term sheet (a “Future Financing”), in either case, on a one-for-one basis (subject to anti-dilution adjustment) at the option of the holder; provided however, if such conversion is in connection with a Future Financing, that the holder may convert into shares of Future Preferred only in the event that all of such shares of Future Preferred received by the holder upon conversion are sold to an Approved Investor (as defined below) no later than 90 days following the first closing of the Future Financing at a price per share no lower than the price per share at which the Company sells shares of such Future Preferred in the Future Financing and, provided further, that such Approved Investor is not an affiliate, family member, or related party of the holder. For the purposes of the preceding sentence, “Approved Investor” means (1) a bona fide institutional investor, or (2) any investor who has invested at least $1 million in the Company. For the avoidance of doubt, any conversion into Future Preferred in connection with a Future Financing that does not result in a sale of such Future Preferred to an Approved Investor on the terms set forth above shall be void, and such Future Preferred shares shall be deemed re-converted into Series A Preferred Stock automatically and without further action on the part of the holder.

Basically, this is a variation on Series FF stock that I have previously written about.  Instead of the stock being issued to founders, the “upgradeable” Series A stock is issued to early investors.  If the early investors want to sell their stock to investors in a later financing round, the Series A stock is convertible into the later round of preferred stock.  This is helpful for early investors who may want liquidity prior to the sale of the company or an IPO.  Assuming the Series B is sold at $2 per share and the Series A was sold at $1 per share, the Series B investor typically would not want to pay $2 per share for a Series A stock with price-based rights (i.e. liquidation preference) at $1 per share.  Of course, allowing an exchange of stock with a lower liquidation preference to a stock with a higher (and potentially senior) liquidation preference is detrimental to the holders of common stock.

I have seen somewhat similar provisions in the past in a slightly different context. In early stage Series A financings, some investors have tried to eliminate certain provisions, such as registration rights, from the standard documents to decrease the complexity and length of typical financing documents. However, these investors want the benefit of rights given to future investors. For example, I have seen a term sheet provision that provides for “most favored nation” status.

When the company raises a Series B financing, the terms of the Series A shall be amended to be at least as favorable as those granted to the Series B.

The problem with this provision is that it is not precise enough.  For example, one might interpret this to mean that price-based provisions (such as liquidation preferences) would be upgraded.

As an alternative, I have used the following term sheet provision in seed stage Series A financings where the investors received a Series A preferred stock with a liquidation preference and no other rights.

If the Company grants registration rights, information rights, rights of first offer, price-based antidilution protection, protective voting provisions or other similar rights to new investors in a subsequent financing involving the sale of additional series of Preferred Stock, the Company will use reasonable efforts to extend such rights to the Purchasers on the same basis granted to new investors. The Company also agrees to use reasonable efforts to provide that holders of greater than 400,000 shares of Preferred Stock will receive any rights customarily having minimum stockholding requirements.

In any event, I wouldn’t be surprised if more sophisticated early-stage investors that want to sell their stock prior to a sale of company or IPO started started asking for “upgradeable” preferred stock.

How do the sample Y Combinator Series AA financing documents differ from typical Series A financing documents (or what’s the difference between seed and venture financing terms)?

August 23, 2008

Y Combinator recently published forms of Series AA equity financing documents that YC portfolio companies have used when raising angel financing.  YC provides a three month startup program for entrepreneurs twice a year in Cambridge, MA and Mountain View, CA.  YC typically provides $5K plus $5K per founder of seed funding for usually 6% of the equity in common stock (which, as an aside, Sarah Lacy seems to question, but in my mind seems like something that I would jump at if I were a fledgling entrepreneur).

[Disclaimer/disclosures:  Please read the disclaimer on the documents and on my website.  I write this blog in my personal capacity and my opinions may differ from my colleagues.  WSGR represents Y Combinator and many of its portfolio companies.  I represent a YC portfolio company that provides the Chatterous application and have worked with Y Combinator founder Trevor Blackwell’s company Anybots.  I have also represented investors that have invested in a couple of YC portfolio companies.  I may update this post in the future.]

I was planning to write a post on the differences between angel financing terms and venture capital financing terms, and thought that the YC documents provided a good opportunity to explain the differences.  I’ve already noticed some commentary about the documents and decided to provide some more detailed explanations and the situations that they might be used.

If you want to review annotated Series A venture capital financing documents, please review the NVCA model venture capital financing documents.  (Please note that I think that the default provisions in the NVCA documents are generally fairly investor-favorable and reflect east coast practice rather than Silicon Valley practice.  I will probably write a post about these documents at some point in the future.)  This post assumes that you have a basic understanding of Series A financing terms.  If you don’t, please educate yourself on this site, Venture Hacks and the term sheet series by Brad Feld/Jason Mendelson, among other places.

What situations should these documents be used in?

The YC documents are probably fine in situations where the investor (i) wishes to purchase equity rather than convertible debt, (ii) is otherwise somewhat indifferent on terms other than percentage ownership of the company, liquidation preference and right of first offer in future financings, (iii) is investing at a fairly low valuation (i.e. a couple of million dollars), and (iv) is only investing a small amount (i.e. a couple hundred thousand dollars or less).

In my experience, sophisticated angel investors expect to receive a full set of Series A documents with rights essentially the same as venture capital investors, so the Series AA documents may not be acceptable in these situations.  I think these documents are most appropriate in a friends and family equity seed financing.  However, I believe that companies are generally better off with convertible debt rather than an equity financing at a low valuation.

Why is it called Series AA?

To differentiate it from typical “Series A” preferred stock, which comes with certain expectations with regard to rights.  I’ve had clients rename their Series A, B and C to Series A-1, Series A-2 and Series A-3, so that their first institutional venture capital financing was called the Series B.  There is no real rule to what a particular series of preferred stock is called (i.e. Series FF for the Founders Fund invention).  I suppose that YC could have named it Series YC, instead of Series AA, for better branding.

What rights does the Series AA have in the sample YC documents?

Obviously, please read the term sheet. The primary rights in these documents, ranked in order of importance in my opinion are:

  • Right of first offer on future financings.  Please note that these documents provide that the right of first offer expires five years after the financing, which I believe is not standard (but happens to be the company-friendly default in the WSGR form of documents that the Series AA documents were based on).
  • Information rights.  The investor receives unaudited annual and quarterly financial statements.

There are situations where an investor might receive stock with even less rights.  For example, if a founder contributes a significant amount of cash (i.e. enough to buy a car) to fund the company, then I might suggest that the company issue preferred stock with a liquidation preference and no other rights to the founder, as opposed to issuing common stock.  The reason for issuing preferred stock instead of common stock is to preserve a low common stock value for option grants as explained in this post, and providing the stock with a liquidation preference.

What are the primary rights that are missing from the these documents that a VC or sophisticated angel would expect?

Some people have suggested that various terms are unnecessary in early stage Series A financings.  See the VentureBeat article titled “Reinventing the Series A.”  In the sample YC documents, there are various terms that are missing that one would typically expect in a company-friendly Series A term sheet (i.e. one from Sequoia Capital).

  • Dividend preference.  Deleting the dividend preference is not a big deal, as almost all startup companies don’t declare dividends.  The only practical situation that I can think of where a dividend preference is beneficial to a stockholder is where a company does a partial sale of assets and wishes to distribute the proceeds to stockholders. The liquidation preference would not apply in this situation, and any distribution to stockholders would trigger the dividend preference.
  • Registration rights.  As a practical matter, I don’t think that most investors should really care about registration rights, especially in light of the shortening of the Rule 144 holding period to 6 months.  (I suppose I will write a boring post about Rule 144 at some point.)
  • Anti-dilution protection.  Deleting anti-dilution rights saves several pages of text in the Certificate of Incorporation. Given that the Series AA is issued at a fairly low valuation, anti-dilution protection is probably not that important, as a “down round” from a low valuation in the Series AA is unlikely.
  • Comprehensive protective provisions.  The YC documents are fairly light on protective provisions compared to a typical Series A financing.
  • Right of first refusal and co-sale.  These rights are missing.  This is probably okay assuming that the founders restricted stock purchase agreement has a right of first refusal on transfers until a liquidity event.  The right of first refusal on founder stock transfers in a typical restricted stock purchase agreement is in favor of the company.  (Please note that when I say typical, I mean an agreement drafted by attorneys experienced in venture financings, not the boilerplate you might get from an online incorporation service.)  The typical RFR/co-sale agreement in a venture financing gives the investors a right to purchase the shares if the company does not exercise its right.
  • Voting agreement.  An optional bracketed provision in the Certificate of Incorporation provides for a Series AA board seat.  In a typical venture financing, there would also be a voting agreement that governs how specific board seats will be filled.  In angel financings, I typically eliminate the voting agreement anyway and simply have a closing condition that the board consist of certain persons.
  • Comprehensive representations and warranties.  The Series AA Preferred Stock Purchase Agreement has fairly limited reps and warranties.  As a practical matter, investors don’t sue companies for a breach of reps and warranties, so reps and warrants basically serve to flush out diligence issues.  In an early stage company, extensive reps and warranties are probably unnecessary.
  • Legal opinion.  A company counsel legal opinion is missing in these documents.  A legal opinion for a newly-incorporated early stage company probably doesn’t add much to the due diligence process and is probably unnecessary compared to the incremental cost to prepare.
  • Legal fees.  Each side pays its own legal fees in these documents.  Venture funds expect the company to pay investor counsel fees.

Do I need an attorney to help me complete a financing if I have these documents?

Yes.  Absolutely.  These documents are not intended to be “fill in the company name,” sign the docs and collect checks/wire transfers.  The fact that certain rights were intentionally omitted from the documents compared to typical VC financing documents is a judgment call that requires the guidance of an experienced attorney. There are always various corporate housekeeping matters that need to be cleaned up in connection with a financing.  Please don’t try to use the YC documents without working with a competent attorney.

What is Form D and what information gets publicly disclosed to the SEC regarding a financing?

August 3, 2008

The SEC adopted new rules regarding Form D, which is routinely filed by companies for venture financings relying on one of the securities exemptions under Regulation D of the Securities Act. Regulation D is a exemption from the onerous registration requirements (i.e. a Form S-1 registration statement) of the Securities Act for a private placement of securities.

Form D is currently filed in paper format and must be filed within 15 days of the first sale of securities in the offering. Paper filings can be accessed through the SEC public reference room, and some third-party services provide information on Form Ds by scanning the paper filings. Some publications covering private company financings routinely monitor information on Form D filings from these third-party services, and often announce details of venture financings discovered in Form D filings.

Effective March 15, 2009, the old paper version of Form D will be eliminated, and electronic filing of the new version of Form D will be mandatory. The SEC’s new online filing system for Form D is expected to be available September 15, 2008, after which there will be a six-month transition period during which companies will have three options for filing a Form D: (i) filing the old version of Form D on paper; (ii) filing the new version of Form D on paper or (iii) filing the new version of Form D electronically.

Once Form Ds are filed electronically under the new rules, they will be available to anyone via the SEC’s EDGAR website.  Start-up companies that are operating in “stealth” mode or have otherwise made no public announcement of their financings should be aware that Form Ds will be more readily available once electronic filing becomes mandatory. Thus, some venture funds have requested that company counsel in venture financings avoid filing Form Ds.

Failure to file a Form D complicates the ability of the company to comply with state securities laws.  Unfortunately, one of the benefits of filing a Form D and complying with Regulation D is that the company does not need to separately comply with a securities law exemption in each state where the securities are offered. Compliance in each state requires company counsel to confirm that an exemption is available, which may increase costs in a financing if offers are made in multiple states. In addition, exemptions may not be available in certain states based on the fact pattern unless the offering also complies with Regulation D. Thus, any decision to affirmatively avoid a Form D filing should be carefully discussed with counsel.

Please refer to the existing version of Form D for the information that must be disclosed.  Among other things, the amount of the financing, the names of executive officers and directors, and the names of 10% stockholders must be disclosed.  The new rules eliminate some of the disclosure required by the current version of Form D. In particular, companies will no longer be required to identify 10% stockholders by name, or to provide detailed information on the use of offering proceeds. The new Form D will require some new disclosure in other areas, however, including a requirement to provide information on the recipients of sales commissions or finders fees.  In addition, the new rules also clarify when amendments to Form D are required.

[Update:  PEHub, which regularly uses Form D filings to report on venture financing, notes that the new rules require less information that the old rules, and that they will not cite information from the revised form without corroboration.]

What does the legal opinion cover?

January 12, 2008

Company counsel typically delivers a legal opinion to the investors at the closing of a venture financing. The legal opinion in a venture financing generally covers the following:

  • Due incorporation, valid existence, good standing, corporate power to carry on its business, and qualification to do business as a foreign corporation;
  • Corporate power to execute, deliver and perform the transaction documents and issue and sell the shares;
  • Capitalization of the company;
  • Shares issued in the financing are validly issued;
  • All corporate action has been taken;
  • The transaction documents have been duly executed and are enforceable against the company;
  • The transaction documents and issuance of shares do not conflict with the company’s charter documents, material contracts and laws applicable to the company;
  • No governmental approvals are necessary;
  • Exemption from the registration requirements under Federal securities laws; and
  • Absence of litigation

Receiving a legal opinion comprises part of an investors’ due diligence, but is not a substitute for it. Delivering a legal opinion requires a certain level of work by company counsel, which increases legal fees. Although legal opinions are typically offered and delivered in financings involving a venture capital fund, they might not be volunteered or requested in a financing involving angel investors, or a typical bridge financing.

Most arguments among attorneys about legal opinions generally relate to the scope of the legal opinion and seem to revolve around what is customary and the amount of time required to deliver the opinion.

The American Bar Association has a collection of articles for attorneys regarding legal opinions. The Business Law Section of the State Bar of California has also published various Opinion Reports.

What are the conditions to closing of a Series A financing?

December 15, 2007

Almost all Series A Stock Purchase Agreements are drafted so that they contemplate a signing of the agreement, then a closing after certain conditions are met.  These closing conditions may include:

  • Representations and warranties are correct and covenants have been complied with;
  • Securities laws have been complied with;
  • The Certificate of Incorporation has been filed with the Secretary of State of Delaware;
  • Ancillary agreements (such as the Investor Rights Agreement, Right of First Refusal and Co-Sale Agreement, Voting Agreement, Indemnification Agreements and Management Rights Letter) have been executed and delivered;
  • Various closing certificates (such as an officer’s certificate, secretary’s certificate, and good standing certificates) have been delivered;
  • A legal opinion has been delivered;
  • Necessary consents and waivers have been obtained;
  • The Board consists of specified persons; and
  • A minimum number of shares is being sold in the closing.

As a practical matter, most venture financings are signed and closed simultaneously. Once company counsel and investors’ counsel have finalized the financing documents, company counsel collects stockholder consents and files the Certificate of Incorporation.  In financings involving multiple investors, wire transfers (and checks) may be sent to a trust account at company counsel prior to or on the closing date.  Signature pages for the various documents are also collected by company counsel and investors’ counsel.  The funds and signature pages are held in escrow pending the closing.  Once company counsel receives confirmation of filing of the Certificate of Incorporation, the financing is deemed closed (assuming that funds are held in escrow with company counsel).  Company counsel will then wire transfer the funds to the company (and deliver any checks), which occasionally may occur the day after the official closing due to wire transfer deadlines.

If funds have not been held in escrow, then the investors may initiate wire transfers directly to the company after filing of the Certificate of Incorporation and the financing is deemed closed when the company has received the funds.  As a practical matter, stock certificates are typically not delivered to the investors until sometime after the closing, although some investors demand to see a copy of the stock certificate before initiating the wire transfer.

Why should a term sheet be confidential?

December 13, 2007

Venture funds do not want their term sheets disclosed to other potential investors in order to avoid the deal terms being shopped. Below is a typical term sheet provision.

[Confidentiality: Until the initial closing of the financing contemplated by this Memorandum of Terms, the existence and terms of this Memorandum of Terms shall not be disclosed to any third party without the consent of the Company and the lead investor(s), except as may be (i) reasonably required to consummate the transactions contemplated hereby or (ii) required by law.]

Please keep in mind that venture funds typically do not sign non-disclosure agreements. Therefore, the confidentiality provision in a term sheet is not binding until it is signed by both sides. However, I suppose that venture funds need to trust companies not to disclose unsigned term sheets in the same way that companies trust venture funds to not disclose business plans.

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